What is a stablecoin? Understanding the types of stablecoins

Stablecoins are cryptocurrencies linked to other stable assets such as the U.S. dollar or gold. A stablecoin is a global currency that has low volatility and isn’t linked to a central bank. Since most cryptoassets such as Bitcoin and Ethereum have a volatile nature, the need for stablecoins is high as they can offer stability on top of the transactional benefits provided by digital assets.

The volatility of cryptocurrencies such as Bitcoin and Ethereum makes it difficult to use them for daily transactions. No one would one to buy a $4 coffee with $5 because of the volatile nature of crypto assets. Consumers need price stability and adoption of stablecoins can be the next important step for major adoption of decentralized cryptocurrencies.

Ideally, an optimal cryptocurrency should have four main qualities: price stability, scalability, privacy, and decentralization. Of course, a stable coin will have a greater chance of wide adoption if it has some additional traits such as simplicity, easy integration points for partners and allowing exchanges to work with it.

Nevertheless, stability is definitely the most important characteristic a stablecoin should have. Long-term stability is critical for holding and short-term stability will fuel transactions.

Analyzing the three types of stablecoins

Source: medium.com

You may have already heard about Tether, the most popular stablecoin. However, there are in fact three types of stablecoins: centralized IOU stablecoins, crypto-collateralized stablecoins, and non-collateralized stablecoins. Below we will discuss each type.

Centralized IOU stablecoins

Centralized IOU stablecoins are quite straightforward. These digital assets are backed with precious metals or fiat money like the U.S. dollar. The value of centralized IOU stablecoins lies in the representation of another asset.

One of the most notable concerns for this kind of stablecoin is the centralized nature as it will require the trust of an issuing party and pretty strict regulation. When you deposit fiat into the bank account linked with the stablecoin, new crypto coins are generated by the network. When you liquidate stablecoins, the network will burn them.

Let’s see some examples of centralized IOU stablecoins.

TrueUSD

TrueUSD (TUSD) has been launched in March by TrustToken a company specialized in traditional asset tokenization and is one of the most well-known centralized IOU stablecoins.

Unlike Tether, where a single banking partner holds the collateral, the TrueUSD system has multiple companies hold U.S. dollars in their bank accounts.

Also, TrueUSD is publishing the contents of its bank accounts on a daily basis and is also holding monthly audits to ensure transparency. TrustToken’s ICO ended in August 2018 and managed to raise $21,700,000.

Digix Gold

Digix Gold (DGX) is also a centralized IOU stablecoin project that is backed by gold. One gram of gold backs each DGX token.

Digix Gold relies on a Proof-of-Asset (PoA) consensus mechanism, an algorithm that verifies ownership on the Ethereum blockchain. The gold serving as a collateral for Digix is held in a custodian vault in Singapore, called The Safe House. This vault it able to store up to 30 tons of gold. However, Digix is looking to collaborate with more vaults around the world.

Gemini Dollar and Paxos Standard Token

The Gemini Dollar was launched by Gemini Exchange and the Paxos Standard Token (PAX) was launched by Paxos. Both are centralized IOU stablecoins and they were launched in September after getting the green light from the New York Department of Financial Services.

The two stablecoins are ERC20 tokens backed 1:1 by U.S. dollars stored in US-located and FDIC-insured banks. Since both are regulated stablecoins using them for illegal activities would allow law enforcement agencies to seize or forfeit them.

Other notable centralized IOU stablecoins you might want to look into are USD Coin, Arccy, and Stably.

Crypto-collateralized stablecoins

Crypto-collateralized stablecoins are backed by digital assets such as Ethereum. Here are some of the most popular ones:

Dai

MakerDAO is the company that launched the Dai stablecoin. In fact, the company is using a two-coin model: Makercoin (MKR), and Dai (DAI).

Makercoin is a governance token linked to the Maker Platform. Dai is the stablecoin that allows you to lock up Ether in a collateralized debt position (CDP). ETH can be locked up in CDPs in the form of pooled ether (PETH). This will generate Dai for you and interest is calculated on PETH over time.

Maker managed to create a decentralized, trustless and fully transparent stablecoin system that’s a viable alternative to Tether.

Havven

Havven is also a crypto-collateralized stablecoin that uses a two-coin model just like MakerDAO: nomins (nUSD) and havven (HAV).

The nomin has a floating supply to stabilize the price and havvens have a stable supply offering collateral for the system. The value of havven is determined by the projected network fees. Those holding havven can receive dividends from locking funds in a smart contract.

The stability of nomins relies on the value of havvens and is over collateralized by them. Haven managed to raise $30 million during its ICO that ended in March.

Non-collateralized stablecoins

We already analyzed stablecoins collateralized by traditional assets and stablecoins collateralized by cryptoassets. Non-collateralized stablecoins are very different.

You might wonder how can these coins maintain a stable price without being collateralized. The solution is a concept called seniorage shares, invented in 2014 by Robert Sams.

Seniorage shares use a smart contract to act like a central bank in which the monetary policy has one commitment, to issue a currency with a value of $1. As a result, if the price of the stablecoin is too high, the network will issue new coins. Consequently, coins will be burned if the price is too low.

Basis

Basis is an established non-collateralized stablecoin. On-chain supply management is used to stabilize the Basis token.

When the price of Basis is not balanced, the smart contract will bring it back to $1 by increasing or decreasing the supply.

During an early 2018 ICO, Basis raised $133M from a 1,400,000 token supply.

CarbonUSD

CarbonUSD started as a fiat-collateralized stablecoin but once it reaches sufficient scale as a fully-fiat backed stablecoin, it will switch to a hybrid fiat-algorithmic model.

Co-founder and CEO of Carbon, Sam Trautwein, sais the final goal is for Carbon to contain a basket of whitelisted stablecoins which includes a trust-minimized, algorithmic stablecoin.

Right now, Carbon is using the Ethereum blockchain. Nevertheless, the team is planning to transition if to Hedera Hashgraph, an in-development high-throughput protocol.

Conclusion

At the end of September, Blockchain Luxembourg SA published a report that estimates 98% of the total daily trading volume of stablecoins belongs to Tether. All the other stablecoins we mentioned (and the ones we didn’t) are seeking to capture at least a portion of Tether’s daily trading volume.

Demand for traditional assets like fiat money is increased by the demand for centralized IOU stablecoins. Likewise, demand for cryptoassets such as Ethereum is increased by crypto-collateralized stablecoins. In plain English, crypto-collateralized stablecoins provide support for the rapidly expanding cryptocurrency ecosystem while centralized IOU stablecoins sustain the legacy financial system.

While it seems like the battle is taking place mainly between these two types of stablecoins it remains to be seen the role that non-collateralized stablecoins will play and which one will manage to achieve the highest adoption.